10/21/2004 The Dollar, Financial 'Profits' and Reflation *

It has the feel of an unfolding bear market.  For the week, the Dow dropped about 2% and the S&P500 declined 1%.  The Morgan Stanley Cyclical index declined 2% and the Morgan Stanley Consumer index lost 1%.  But the Transports and the Utilities gained less than 1%.  And the broader market continues to show resiliency, with the small cap Russell 2000 (up 2% y-t-d) and S&P400 Mid-cap (up 2% y-t-d) indices about unchanged.  Technology stocks were mixed, although most indices were on the plus-side.  The NASDAQ100 gained 1% this week, while the Morgan Stanley High Tech index declined less than 1%.  The Semiconductors were up 4% and The Street.com Internet index jumped 5% (up 17% y-t-d).  The NASDAQ Telecommunications index was unchanged.  The Biotechs declined 2%.  Financial stocks were mixed, with the Broker/Dealers up 3% and the Banks down 2%.  With bullion up $5.43, the HUI gold index added 1%. The Treasury curve continues to flatten.  For the week, 2-year Treasury yields were about unchanged at 2.52%.  Five-year Treasury yields dropped 6 basis points to 3.25%.  Ten-year Treasury yields sank 8 basis points to 3.98%.  Long-bond yields ended the week at 4.75%, down 10 basis points.  Benchmark Fannie Mae MBS yields declined 7 basis points, about in line with Treasuries.  The spread (to 10-year Treasuries) on Fannie’s 4 3/8% 2013 note narrowed 1 to 30, and the spread on Freddie’s 4 ½ 2013 note narrowed 1 to 26.  The 10-year dollar swap spread declined 1 to 42.5.  Corporate bonds were mixed, with investment grade performing well and junk appearing vulnerable.  The implied yield on 3-month December Eurodollars rose 3 basis points to 2.275%.  There was about $10 billion of corporate issuance this week (from Bloomberg).  Investment grade issuers included Atmos Energy $1.4 billion, HSBC Bank $1.0 billion, Wachovia Bank $1.0 billion, BB&T $600 million, Brandywine Realty $525 million, Limited Brands $500 million, Codelco $500 million, Block Financial $400 million, Arch Western $250 million, Entergy Gulf States $200 million, and Eaton $75 million.              The streak of junk bond fund inflows ended at nine weeks, although this week’s outflow was less than $1 million (from AMG).  Issuers included Advanced Micro $600 million, New Skies Satellite $285 million, Markwest Energy $225 million, Polymer Holdings $150 million, Reddy Ice Holdings $150 million, Abraxas Petro $125 million CBD Media $100 million, and Pan American $100 million.  October 21 – Bloomberg (Karen Brettell):  “Sales of notes that pay returns linked to stocks, commodities, currencies and other assets may rise to a record $12 billion in the U.S. this year as investors seek alternatives to low bond yields and falling stocks, according to JPMorgan Chase & Co. The amount of so-called structured notes registered with the Securities and Exchange Commission may grow 20 percent from 2003…” Foreign dollar debt issuers included Kazkommerts International $350 million, Elec de Caracas $260 million and Cosan SA $200 million.     October 22 – Financial Times (Charles Batchelor):  “The European repo - or repurchase - market grew by 19 per cent to 4,561bn in the year to June as banks attempted to get the maximum value from their cash balances, the International Securities Market Association (ISMA) said.” Japanese 10-year JGB yields rose 4 basis points to 1.48%.  Brazilian benchmark bond yields increased 5 basis points to 8.64%.  Mexican govt. yields ended the week at 5.12%, down a notable 11 basis points.  Russian 10-year Eurobond yields sank 25 basis points to 5.78%.  Freddie Mac posted 30-year fixed mortgage rates declined 5 basis points this week to 5.69%, the lowest borrowing cost since the first week of April.  Fifteen-year fixed mortgage rates dropped 7 basis points to 5.07%.  One-year adjustable-rate mortgages could be had at 4.02%, up one basis point for the week.  The Mortgage Bankers Association Purchase application index jumped 5.8% last week.  Purchase applications were up about 19% from one year ago, with dollar volume up 34%.  Refi applications rose 10.6% during the week.  The average Purchase mortgage rose to $222,700, while the average ARM increased to $304,100.  ARMs accounted for 34.8% of total applications last week.  October 19 – Dow Jones (Christine Richard):  “Investors don’t expect much from a money market account, especially these days with short-term rates at rock bottom levels, but they do demand one thing - if they invest a dollar, they want a dollar back.  Anything less is called ‘breaking the buck’ and it’s a cardinal sin in the money market fund management business.  But recently, an increasing number of investors with money to invest for the short-term have been willing to risk a small decline in their principal in exchange for a higher yield.  This mostly institutional money is being invested in new categories of short-term investments, currently totaling between $500 billion and $800 billion. These funds - known as short-term funds - are giving the $2 trillion in regulated money market funds a run for their money.  ‘With historically low interest rates, more sophisticated institutions are looking into what are called short-term funds that take more credit risk, more interest rate risk and offer a higher yield,' said Henry Shilling, senior vice president…at Moody’s…” Broad money supply (M3) declined $35.4 billion (week of October 11), with a two-week drop of $75.7 billion.  Year-to-date (41 weeks), broad money is up $476.6 billion, or 6.9% annualized.  For the week, Currency added $300 million.  Demand & Checkable Deposits sank $32.3 billion.  Savings Deposits jumped $33.7 billion.  Saving Deposits have expanded $287.4 billion so far this year (11.5% annualized).  Small Denominated Deposits were about unchanged.  Retail Money Fund deposits declined $7.1 billion, and Institutional Money Fund deposits fell $22.7 billion.  Large Denominated Deposits rose $5.2 billion.  Repurchase Agreements declined $18.7 billion (down $33bn in two weeks), while Eurodollar deposits rose $6.4 billion.             Bank Credit rose $17.6 billion for the week of October 13 to $6.708 Trillion.  Bank Credit has expanded $434 billion during the first 41 weeks of the year, or 8.8% annualized.  Securities holdings increased $11.1 billion, while Loans & Leases gained $6.6 billion.  Commercial & Industrial loans expanded $4.0 billion, while Real Estate loans jumped another $9.2 billion ($29.5 billion over two weeks).  Real Estate loans are up $256.4 billion y-t-d, or 14.6% annualized.  Consumer loans dipped $3.8 billion for the week, and Securities loans declined $9.6 billion. Other loans rose $6.7 billion.  Elsewhere, Total Commercial Paper rose $5.7 billion to $1.357 Trillion (up $27.2bn in three weeks).  Financial CP added $3.0 billion to $1.222 Trillion, expanding at a 6.6% rate thus far this year.  Non-financial CP increased $2.7 billion (up 31.4% annualized y-t-d) to $135.4 billion.  Year-to-date, Total CP is up $88.9 billion, or 8.7% annualized.  Year-to-date ABS issuance of $511 billion is 42% ahead of comparable 2003 (from JPMorgan).  2004 home equity ABS issuance of $327 billion is running an astounding 89% ahead of last year’s record pace. Fed Foreign “Custody” Holdings of Treasury, Agency Debt rose $6.1 billion to $1.294 Trillion. Year-to-date, Custody Holdings are up $227.5 billion, or 26.4% annualized.  Federal Reserve Credit added $1.8 billion last week to $770.5 billion, with y-t-d gains of $22.2 billion (3.8% annualized).  Currency Watch: The dollar index closed today below 86 for the first time since February.  The dollar traded to an eight-month low against the euro and four-month low against the yen.  The Canadian dollar this week traded to a 12-year high.  For the week, the South African rand jumped 4%, the yen 2%, and the Swiss franc, Swedish krona, Norwegian krone and Danish krone all just under 2%.  But our currency did outperform the Zimbabwe dollar (down 3.8%), Nigeria naira (down .6%), Uruguay peso (down .6%), Mexican peso (down .5%), and Brazil real (down .4%). Commodities Watch: October 21 – Bloomberg (Xiao Yu):  “China’s September copper imports rose 43 percent from a month earlier to their highest since April, as domestic producers started to replenish stockpiles. Copper imports were 110,844 metric tons, from 77,278 tons in August, according to the Beijing-based customs office. They were last higher in April at 142,349 tons before falling as China tightened lending controls to damp economic growth, which the government blamed for driving up prices of steel, aluminum, copper and other commodities.” October 19 – Bloomberg (Tan Hwee Ann):  “Coal and iron ore prices may rise as much as 64 percent in the year starting April 1, as expansion by Chinese steelmakers drives global demand for raw materials, Merrill Lynch & Co. said. The benchmark Japanese contract price for coking coal, used to make steel, may rise 64 percent to $95 a metric ton in the next fiscal year, from $58 this year, the brokerage said in a report. Iron ore prices may rise as much as 22 percent.” October 21 – Bloomberg (Matthew Craze):  “Tin inventories in warehouses monitored by the London Metal Exchange may fall to 25-year lows next year as electronics and computer companies switch to lead-free solder, two research bodies for the industry said. Record production of mined tin won't be able to keep up with demand…” Rising 20% this week, natural gas traded to a 20-month high.  With December crude up $1.20 to a record $55.17, the Goldman Sachs Commodities index rose 2.9% this week.  This increases year-to-date gains to 42.5%. The CRB index added 0.3%, increasing y-t-d gains to 12.2%.     China Watch: October 21 – Bloomberg (Netty Ismail and Melanie Bull):  “China’s government raised $1.7 billion selling bonds, including its biggest offering of debt in the European currency, and paid the minimum interest that it targeted after getting excess demand. China priced 1 billion euros ($1.26 billion) of 10-year bonds, the longest maturity of such a security sold by an Asian government, to yield 40 basis points more than mid-swaps… The bonds, maturing on October 28, 2014, will pay a coupon of 4.25 percent.  The government also sold $500 million of five-year bonds to yield 60 basis points more than U.S. Treasuries…” October 19 – Financial Times (Alexandra Harney):  “Rising world commodity prices are narrowing Chinese exporters’ already-slim profit margins and forcing them to charge more for their goods.  Chinese manufacturers at the country’s largest trade exhibition, the Canton Fair, said this week that sharp increases in the prices of oil, steel, copper and plastic were making it necessary for them to raise prices to foreign buyers.  But they have not been able to pass on the entire increase in material prices to their customers, cutting into their profitability.  ‘It’s killing me,’ said Sunny Chan, director of Guangzhou-based lighting manufacturer Tak Fu Hong Trading, of the oil price rise. ‘The steel price has doubled in the last eight months. Plastic has doubled. It has doubled - not just [risen] 10 per cent. It’s terrible.’” October 20 – Bloomberg (Wing-Gar Cheng):  “China’s crude oil imports rose 34 percent to 90.3 million metric tons in the first nine months of the year compared with a year earlier, Beijing-based Customs General Administration of China said… In the first eight months of the year, China's oil imports rose 39 percent and fuels imports gained 36 percent.” October 21 – Bloomberg (Wing-Gar Cheng and Loretta Ng):  “China’s crude oil import growth slowed to 5.7 percent in September from 37 percent in August, underscoring a prediction by the International Energy Agency that record-high international prices may curb demand for the fuel.” Asia Inflation Watch: October 21 – Bloomberg (Lily Nonomiya):  “Japanese exports rose 12.5 percent to a record in September, led by shipments to Asian markets including China and Taiwan… Export growth accelerated from a 10.4 percent increase in August from a year earlier, the Ministry of Finance said… The trade surplus widened 12.7 percent to 1.24 trillion yen ($11.5 billion.)…” October 21 – Bloomberg (Theresa Tang):  “Taiwan’s export orders rose 26.6 percent in September to a record $19.5 billion from a year ago as the island sold more electronic goods and cell phones, the ministry of economic affairs said. The pace in the growth of orders, indicative of shipments in one to three months, accelerated from a 26 percent increase in August.” October 20 – Bloomberg (Laurent Malespine and Arijit Ghosh):  “Thailand’s central bank Raised its benchmark interest rate by a quarter point for the second time in two months to curb inflation fueled by record crude oil prices… Inflation is accelerating in Thailand, the Philippines and Taiwan, putting central banks under pressure to raise rates.” October 19 – Bloomberg (Christina Soon):  “Singapore’s inflation may accelerate as companies pass rising fuel costs on to consumers, the island’s central bank said in its macroeconomic review.  For every 10 percent increase in oil prices, Singapore’s consumer prices will rise by 0.2 percentage point and gross domestic product will drop by between 0.1 percentage point and 0.2 percentage point, the central bank said… ‘There are upside risks to external inflationary pressures from stronger commodity prices, as well as the potential for a higher degree of pass-through of these cost increases,’ the central bank said…” October 19 – Bloomberg (Khoo Hsu Chuang and Chan Tien Hin):  “Malaysia’s economy may expand 7.2 percent this year, led by exports and consumer spending, while growth in 2005 will probably be undermined by higher oil prices, the Malaysian Institute of Economic Research said.” October 20 – Bloomberg (Adeline Lee):  “Malaysia’s vehicle sales rose for an eighth month in September as new models, cheap loans and an expanding economy lured consumers.  Sales of passenger cars and commercial vehicles last month rose 28 percent from a year earlier to 43,495 units…” Global Reflation Watch: October 21 – Bloomberg (Gonzalo Vina):  “U.K. retail sales unexpectedly rose in September as discounting in stores spurred purchases of mobile telephones, carpets and sports equipment. The volume of sales climbed 1 percent in September, compared with a revised 0.7 percent increase a month earlier… On the year, sales rose 6.9 percent compared with 6.5 percent in August.” October 20 – Bloomberg (Duncan Hooper and Sam Fleming):  “U.K. mortgage lending fell in September and shares of house building companies slid on mounting evidence that Britain's five-year property boom is coming to an end amid rising interest rates.  Gross lending slipped to 25.4 billion pounds ($46 billion), from 25.9 billion pounds in September 2003, the first annual decline in almost four years…” October 21 – Bloomberg (Halia Pavliva and Todd Prince):  “Russia’s foreign currency and gold reserves rose to a record $110.1 billion, meeting the central bank’s year-end target, as exporters’ revenue rose with oil prices, the country’s major export commodity.   The central bank said reserves rose 1.8 percent in the week…compared with $98.3 billion a week earlier, gaining for the eighth week. Reserves rose 7.2 percent in September alone.” October 21 – Bloomberg (Halia Pavliva):  “Russian retail sales rose an annual 12.5 percent in September, the fastest increase in the past three months, as the growing economy boosted purchasing power.” October 21 – Bloomberg (Halia Pavliva):  “Russian producer prices rose a preliminary 2 percent in September from August, the fastest pace since June, led by oil extracting, fuel and metal-making… Prices rose 25.6 percent from the same month a year ago…” October 19 – Bloomberg (Katia Cortes):  “Brazil’s federal tax revenue rose 27.4 percent in September as a surge in consumer demand enabled the government to collect more from companies such as Alcoa Inc., which were boosting output and increasing local sales.” U.S. Bubble Economy Watch: October 20 – Bloomberg (Vivien Lou Chen):  “The two busiest U.S. ports face a ‘critical’ backlog of cargo in Southern California, stemming from higher demand for Asian goods, said a union representing dock workers. The union wants a 24-hour workday to move cargo during off-peak hours at the ports in Los Angeles and Long Beach, California, said James Spinosa, president of the International Longshore & Warehouse Union… The backlogs ‘are at a critical stage and the consequence of poor planning and investment,’ Spinosa said…” October 20 – Dow Jones (Liz Rappaport):  “The high yield bond market remains a panacea for many individual investors seeking income-producing returns, but the risks are high and advisers warn that the party may soon be over. Individual investors have been hard pressed to find decent returns from the usual places. The stock market is expected to provide flat returns at best this year, and safe-haven bonds like Treasury bonds or high-grade corporate bonds have reached near record low yields.” Mortgage Finance Bubble Watch: October 20 – Dow Jones (John Connor):  “The Federal Home Loan Bank System is big and getting bigger.  Sometimes, just a few numbers can tell a story. The system’s top regulator provided a few such numbers in a speech Tuesday to a group of bankers.  ‘As of June 30 of this year, total assets of the 12 Federal Home Loan Banks were $902 billion,’ said Alicia Castaneda, who chairs the Federal Housing Finance Board. ‘That represents an increase of 9% during the first half of 2004.  ‘By comparison, at the end of 2000, total assets were about $675 billion,’ Castaneda said. ‘And, going back further, to 1990, assets were about $175 billion. So, taken in their entirety, the Banks have grown...and grown dramatically.’” After a couple of slow months, Fannie pressed the accelerator during September.  For the month, Fannie’s Book of Business increased $18.1 billion, or 9.6% annualized to $2.282 Trillion.  The company’s Book of Business has grown 5.1% y-t-d, and is up 7.2% from one year ago.  Fannie’s Retained Portfolio expanded by $9.3 billion, or at a rate of 12.5%, during September to $904.8 billion.  The company’s Retained Portfolio has expanded at about a 1% rate so far during 2004 and is down slightly over the past 12 months.  Freddie Mac posted a slower September.  For the month, the company’s Book of Business expanded at a 4.8% rate to $1.489 Trillion.  Freddie’s Retained Portfolio declined slightly to $660.7 billion.  Year-to-date, Freddie’s Book of Business has expanded at a 7.1% rate and the company’s Retained Portfolio at a 3.1% rate. Earnings Watch: JPMorgan earnings significantly missed Wall Street estimates.  With Bank One consolidated into JPM this quarter, comparisons are not straightforward.  But Revenues were generally weak throughout, with Investment Banking and Trading notable for their poor performance.  Trading Revenues were down 50% from disappointing second-quarter results and down 65% from last year’s third-quarter.  Traders and clients were positioned for higher interest-rates.  Management has indicated that weak results in proprietary trading will dictate a refocus of its emphasis more toward client trading and less on its own.  But Retail Banking performance also lagged.  Credit performance was also not encouraging, while expense growth was strong.  Wells Fargo missed Wall Street earnings estimates, although Net Income was up 12% versus the prior year period to $1.75 billion.  Residential mortgage originations dropped 29% to $68 billion (as Countrywide gains share).  Total Loans expanded at a 14% rate during the quarter to $279 billion.  Commercial Loans expanded at a respectable 6.3% pace, although this was down from the second quarter’s 16%.  Real Estate Construction Loans increased at a 26% annualized rate.  Total Consumer Loans expanded at a 32% pace, led by Home Equity (48% ann.) and Credit Card (34% ann.).  Total Assets expanded at a 1% rate during the quarter after expanding at a 23% rate during the second quarter. Countrywide Financial badly missed Wall Street estimates and lowered guidance going forward.  Net Earnings were down 47% from third quarter 2003 to $582 million.  At $91.8 billion, mortgage originations for the quarter were strong and the company gained market share.  But volume came at a cost, as margins contracted significantly.  Total Assets increased only $635 million, or 2% annualized, to $104.4 billion, the slowest asset growth in nine quarters. California ARM lender Golden West Financial reported record mortgage originations for the quarter of $14.1 billion, up 40% from the year earlier quarter.  Total Assets expanded at a 30% annualized rate during the quarter to $100.2 billion, with y-o-y gains of 32% (up 53% over two years).  While Net Earnings were a record $325 million, sequential earnings growth of 10% was the weakest in 7 quarters.  Earnings growth of 15% from one year ago compares to assets growth of almost a third.  Washington Mutual Total Assets expanded $10.3 billion, or 15% annualized, to $288.8 billion, the strongest growth in over two years.  Net Income of $674 million was better-than-expected, but we don’t expect the unfolding battle for mortgage-lending profits to be kind to Wamu.  Thornburg Mortgage REIT Total Assets expanded at a 31% rate during the quarter to $26.45 billion.  Assets were up 53% y-o-y.  Total Shareholder’s Equity increased $128 million during the quarter to $1.684 billion.  Assets have ballooned from $5.3 billion just three years ago. Capital One reported Net Earnings for the quarter of $490.2 million, up 78% from comparable 2003.  Total Assets expanded at a 15% rate during the quarter and were up 20% from one year ago.  One the liability side, Deposits expanded at a 19% rate during the quarter to $25.4 billion (up 21% y-o-y). Americredit beat earnings estimates, although Credit quality appears to be deteriorating.  For the quarter, charge-offs jumped to 6.4% from the previous quarter’s 5.0%.  Delinquency rates also increased.  Total Assets expanded at a 31% rate during the quarter to $9.5 billion and were up 19% y-o-y. The Dollar, Financial “Profits” and Reflation It’s been some time since I partook in a bout of fruitless shadow sparing with my “analytical nemesis” Paul McCulley.  But I have a fundamental disagreement with his analysis that I believe lies at the very heart of the most important economic issue of our time.  Mr. McCulley is (from reading his latest) determined to “dig in his heels,” and so will doug.  He believes the Fed executed sound policy in fighting “deflation” back in 2002.  My view is that the Fed recklessly stoked Credit Bubble blow-off excesses – especially throughout mortgage finance and leveraged speculation.  He believes the Greenspan Fed made things better, while I believe the Fed’s reflation strategy greatly compounded previous policy mistakes and exacerbated systemic fragilities.  There can be no reconciliation of these diametrically-opposed policy views today, tomorrow or the next day.  One of us is going to be “proved” wrong.  (And I plan on fighting historical revisionism, Fed apologists and neo-Friedmanites as long as anyone will read my analysis). As an analyst, ideology is The Seductive Antagonist.  It is there to bias my objectivity and provide a convenient blurred lens with which my mind is happy to use to fabricate a view of the world and how it works (while fellow ideologues rejoice and adulate).  I am certainly not a Keynesian, although I similarly wouldn’t subscribe to an ideology that yearns to burn him at the stake.  Keynes was a great economist.  And I will go further by stating my view that there is a time and place for aggressive “Keynesian” government intervention. Politicians are bound to make mistakes, as are monetary policymakers, bankers, businesspersons, market participants and markets – although the determined goal must be to avoid major errors.  In a post-Bubble environment, monetary and fiscal stimulation hold the potential to play a constructive role in supporting spending, buttressing confidence and medicating a sick Credit system. Still, much rests on a paramount issue:  While aggressive stimulation (monetary as well as fiscal) may prove helpful in a post-Bubble environment, it is at the same time most harmful during the Bubble.  Aggressive stimulation must be administered with great forethought and circumspection.  Like war, there must be a plan to “win the peace” – ensure that stimulation is fostering sound Monetary Processes, as opposed to dysfunctional speculation and asset inflation – and there must be an endgame.  There is great systemic risk in directing overwhelming force against the wrong target. Moreover, I will argue strongly that “Keynesian” stimulation is surreptitiously destructive and potentially disastrous when it prolongs and exacerbates late-stage excesses, distortions and imbalances.  And as inherently mesmerizing as this process – fighting the inevitable consequences of faltering Bubbles with only more potent stimulation - becomes for politicians, the prospering business and market “class,” an increasingly indebted and inflated asset-exposed general populace, and error-prone (and nervous) central bankers, great care must be taken to avoid a quagmire.  The late-twenties period provides a poignant case in point.  And we conveniently disregarded the lesson from Japan as to how important it is to avoid financial and economic Bubbles.  In fact, our policymakers took “lessons not learned” to a whole new level by concocting a theory that aggressive stimulation early is the best remedy – “Keynesianism” and analysis at their absolute worst.  There will be a huge cost for wasting most of our policy ammo. It therefore becomes a requisite focal point of both analysis and policymaking to study and address Bubble dynamics.  Most regrettably, the Greenspan Fed has abrogated its responsibility with its fallacious assertion that Bubbles are recognizable only after the fact.  Meanwhile, virtually all analysts having anything to do with Wall Street, the lending business or the general Credit system similarly keep their distance from Bubble examination and contemplation – at least publicly.   It is, after all, more expedient to parse the problem and solution in terms of “fighting deflation” (who in this country doesn’t think that is a good idea?), while driving us smack into an analytical and policy dead end.      But while the public debate is ordained to No Man’s Land, this can only for so long misrepresent the reality of pernicious – although certainly not commonly recognized – developments.  Admittedly, for most days, weeks, months, quarters and, even, years, one can live a happier, more productive and profitable life playing right along with the charade that all is well and that our business leaders, market professionals, politicians and Alan Greenspan have everything well under control.  George Soros’ Theory of Reflexivity helps us appreciate how everyone believing that things are well under control, by God, helps immeasurably to ensure that things remain under control.  By their very nature, financial and economic booms become Confidence Games, the seriousness of the stakes involved and the acts to sustain confidence corresponding to the age of the boom.  History teaches us that markets are predisposed to occasional manic periods of over-shooting; economies can dangerously over-shoot; and Credit systems can disastrously over-shoot.  The great challenge today is to not be blindsided by the inevitable tornado adjustment period.  They do, by there nature, develop when most think they see nothing but clear skies.  Mr. McCulley avers that the Fed “acted appropriately,” if belatedly, in firing its “anti-deflationary weaponry” back in 2002 and the “risk of deflation is now relieved.”  I see things much differently.  The issue was not “deflation” but a vulnerable Credit Bubble, and the corporate debt crisis of 2002 was not symptomatic of global deflationary pressures as much as it was an inevitable consequence of previous excesses and malfeasance.  There was no cure, and the cancer has spread. And what do we have to show for the past 24 months of reflation?  Well, we witnessed a full-fledged rush to yield and risk-taking, with booms throughout the junk and emerging bond markets.  There has been a proliferation of higher-yielding quasi-money market funds that could very well prove one of the poorest risk vs. return vehicles Wall Street has ever created.  Derivatives – especially the key currency, interest-rate and Credit risk markets – have mushroomed.  The hedge fund and leveraged speculating community have seen massive inflows and taken on unparalleled leverage. The GSE Bubble only grew more problematic.  There has been an unprecedented boom in mortgage REITs that has all the appearances of late-stage leverage and real estate Bubble folly.  The system has added an additional $2 Trillion of suspect mortgage debt at very low yields.  California home prices have surged 50%, with further dramatic inflation for already inflated “upper-end” properties throughout the country.  We’ve borrowed well over $1 trillion from foreign-sourced creditors.  This borrowing has by and large financed consumption, with alarmingly minimal productive investment.  Crude oil has surged to $55, the Goldman Sach Commodities index has doubled, and the price of doing business in the U.S. has further inflated. I will be the first to concur that deflation does seem quite “relieved” at this point.  But relief from a faltering Credit Bubble is spelled M-A-S-S-I-V-E  &  U-N-R-E-L-E-N-T-I-N-G  R-E-F-L-A-T-I-O-N.  This is truly a war that cannot and will not be won.  In this regard, there are two critical and interrelated developments that support my view that reflation is approaching the brink:  Both the dollar and financial “profits” are faltering.    I have written in the past how the traditional Banking system – dominated by bank loan officers and benign bank loans – was supplanted by Contemporary Finance with its cadre of investment bankers, marketable securities, derivatives, Credit guarantees/insurance and leveraged speculators.  It was this multi-decade transformation of debt into marketable instruments that set the stage for a historic mania and financial folly.  What a Bubble it all became.  And the Fed’s war against deflation was precisely the policy mistake to needlessly stimulate spectacular “blow-off” excesses.  These excesses – a.k.a. “reflation” - involved massive dollar support, massive mortgage lending, massive speculation in Credit market instruments, and massive leveraging.  There was no need for the Fed to inflate its balance sheet or instigate “unconventional measures” with the ongoing massive inflation of dollar debt securities on foreign and domestic balance sheets. The faltering dollar - concurrent with dissipated returns for the over-crowded leveraged speculating community and rapidly faltering “profits” for the bloated financial sector – could now spell serious trouble for the reflation process.   It is tonight worth noting that key financial institutions – including Fannie, Freddie, Citigroup, JPMorgan, AIG, and MBIA, to name a few  – have good reason to now adopt a more risk-averse posture in the marketplace.  Beyond important regulatory issues, the proprietary trading desks haven’t been able to show returns commensurate with the risks they have been taking.  At the same time, the ballooning mortgage lenders are in the process of destroying lending profits for themselves and others (including banks and Credit card companies).  Meanwhile, the hedge funds – with investor expectations so high – have been struggling to make ends meet, with the very distinct possibility that things are about to turn much worse.  Speculative losses would beget de-leveraging, further losses, outflows, and further de-leveraging. The financial sector is looking increasingly suspect, which questions its capacity to continue to generate the massive Credit growth required to Retain Reflation.  The Great Credit Bubble is today vulnerable to risk aversion from its myriad financial players – its “risk intermediators” – that must transform increasingly risky loans into perceived safe and liquid instruments.  And any time we are left to question the sustainability of reflation we must immediately contemplate Acute Financial and Economic Fragility.  If one scripted how the final stage of a historic Bubble in marketable debt instruments might appear, I think it would much resemble the way things are these days.  I will conclude with the most important point – one not addressed by Mr. McCulley, or anyone else for that matter.  A truly momentous failure of analysis and policymaking revolves around the issue of systemic liquidity created in the process of leveraged speculation of debt instruments (having gone to “blow-off” extremes).  Highly leveraged speculative finance has become the key source of liquidity for both the financial system and Bubble economy.  Similar dynamics were at the heart of the 1929 financial crash and subsequent Great Depression.  This will be a pressing – if unappreciated – issue in the unsettling days, weeks and months ahead.